Taisuke Tanaka, Strategist at Deutsche Bank, thinks markets crossed a threshold into an adverse credit risk cycle globally last week. Key Quotes “Although the BoJ’s negative interest rate initially reassured investors, after just three business days, disappointment with the loss of benefits from yen depreciation triggered a shift to risk-off flows. Making matters worse, Japanese institutional investors are headed for full-year closings at the end of March. These investors have been forced into taking profits and implementing dollar-selling hedges before they consider buying dollars (US bonds) on dips under negative interest rates conditions. Hedge-related flows tend to have a dramatic impact when major market trends turn. The forex hedging ratio (forward net short and long put) for the ¥24.6trn in dollar-denominated assets held by the nine major life insurers was 46.2% at the end of September 2015. The ratio for the ¥7.6trn in euro-denominated assets was 63.4%. We think the hedging ratio was extremely low for unhedged foreign bond investments because hedged foreign bonds accounted for about half of dollar-denominated assets. We estimate that potential dollar-selling hedges could be as high as about ¥10trn on a net basis just for these firms in the event of a lengthy and deep risk-off trend. Besides dollar-selling hedges by Japanese investors, we also expect unwind of yen-selling hedges by foreign investors who own Japanese stocks (these holdings totaled ¥182.8trn at end-September 2015). We estimate that unwinding of yen shorts would be about ¥4.6trn in response to a 10% drop by TOPIX if 25% of these holdings are covered by forex hedges. We expect Japan’s pension funds to continue buy-on-dip dollar purchases as index investors. We also anticipate yen-selling for the portions of Japanese stocks sold by foreign investors. However, we think that once the above-mentioned yen-buying hedge flows ramp up, they will greatly exceed real-money yen-selling flows. We see short-term risks when the USD/JPY breaks below ¥110. The major countries could take collaborative action to address a global risk-off emergency. Japan’s MoF has hoped to maintain a non-intervention stance in the forex market. However, we cannot rule out the possibility of intervention to sustain around 110 to defend Abenomics, particularly given Japan’s tendency to experience vicious cycles of risk-off and yen appreciation.” For more information, read our latest forex news.